A bear market puts a premium on a trustee’s ability to discharge effectively the duty to monitor the trust portfolio in terms of its ability to discharge Settlor objectives and to meet beneficiary expectations. Although portfolio performance communication often consists of either merely reporting returns relative to a benchmark, or of providing lengthy transaction histories, many trustees have recently elected to project the range of expected future performance as well as the probability of future portfolio deficits through the use of risk models. Models based on Monte Carlo simulation methodology are becoming increasingly popular.
We show that many commercially available risk models utilize overly simplistic assumptions. As a result, the outputs are likely spurious and the shortfall projections are not credible. We argue that projected shortfall analysis is a valuable aspect of trust monitoring and communication; and, therefore, should be based on models using defensible and academically sound econometric principles. Further, we introduce a new trust monitoring metric called the Wealth to Annuity Cost Ratio [WACR]. This metric frees the trustee from overreliance on risk projections and asset return forecasts.
The metric is based on current observables rather than assumptions regarding the future. Quite simply, the WACR is a test for solvency. Are current trust assets sufficient to (1) meet the liabilities to provide sufficient income to the current beneficiary, (2) pay targeted terminal wealth to the remaindermen, and (3) meet the ongoing obligation to pay trustee fees and investment costs? If the answer is ‘no,’ the trust violates the “feasibility condition”—a term based on the mathematical concept of a “free boundary” —despite the fact that its current asset value may be substantial. Thus, prudent trust administration requires a focus on the magnitude of a trust’s economic liabilities as well as the performance of its asset allocation lest a trust that is outperforming the S&P 500 finds itself technically insolvent with respect to the Settlor’s objectives.